Ratios and analysis techniques - Common size analysis and se...

Learning Outcomes

This article explains how to apply common size income statement and balance sheet analysis and interpret segment reporting in a CFA Level 1 context. It shows you how to convert income statements into percentage form, distinguish between absolute and relative performance, and interpret key margins such as gross, operating, and net profit margins. You will see how common size statements support cross‑company and time‑series comparisons, reveal cost structure differences, and clarify whether changes in profitability arise from pricing, volume, or expense control. The article also explains how common size balance sheets highlight liquidity, use of debt, and capital structure, and how these percentages link to ratio analysis commonly tested in the exam. In addition, it outlines required business and geographic segment disclosures under IFRS and US GAAP, including revenue, profit or loss, asset information, and the main quantitative thresholds for identifying reportable segments. You learn how to use segment data to assess diversification, isolate high‑ and low‑risk areas, and evaluate the sustainability of consolidated performance. Finally, the article emphasizes practical limitations and typical exam traps in both common size analysis and segment reporting, helping you apply these tools critically rather than mechanically.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the techniques for comparing and analysing financial statements, especially through common size analysis and segment reporting, with a focus on the following syllabus points:

• Prepare and interpret common-size income statements and compare results across companies and periods
• Calculate and interpret common-size balance sheets and related financial ratios
• Describe how segment disclosures improve performance analysis for diversified companies
• Evaluate the impact of business and geographic segment results on risk and profitability analysis
• Identify limitations and key considerations in the use of ratios and segment information

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the main advantage of expressing an income statement in common-size form (each line as a percentage of sales)?
   1. It allows the analyst to avoid calculating any additional ratios.
   2. It eliminates the need to understand the company’s business model.
   3. It makes it easier to compare profitability and cost structure across firms of different sizes.
   4. It ensures that differences in accounting policies no longer matter.
2. When preparing a common-size balance sheet, which base is most appropriate?
   1. Total current assets
   2. Total shareholders’ equity
   3. Total liabilities
   4. Total assets
3. Under IFRS and US GAAP, which operating segments must be separately disclosed as “reportable segments”?
   1. Only those segments located outside the home country
   2. Segments that meet at least one 10% threshold for revenue, profit or loss, or assets
   3. Only the largest three segments ranked by revenue
   4. Segments that management chooses, with no quantitative thresholds
4. A company has two reportable segments. Segment A has a higher operating margin but lower sales growth than Segment B. Which interpretation is most reasonable?
   1. Segment A is likely more profitable but may offer less growth; Segment B may be riskier but a key growth driver.
   2. Segment A is both more profitable and faster growing than Segment B.
   3. Segment B must be discontinued because its margin is lower.
   4. Segment B is less risky because it has lower margins.

Introduction

Evaluating a company's financial health requires more than reviewing raw totals. Differences in firm size, growth rates, and business models can hinder comparison across companies or periods. Standardisation using common size analysis and segment reporting addresses this issue, allowing analysts to draw fair and relevant comparisons and to identify where value is really being created or destroyed.

Key Term: common size analysis
Common size analysis is the process of expressing all items in a financial statement as a percentage of a selected base—typically sales or revenue for income statements, and total assets for balance sheets—to standardise figures for comparability.

Key Term: segment reporting
Segment reporting is the disclosure of financial results for separate identifiable operating divisions or geographic areas within a company, mandated for significant segments under IFRS and US GAAP and based on the segments used internally by management.

For Level 1, the emphasis is on:

• Turning raw income statement numbers into percentages of sales
• Interpreting common-size margins such as gross margin, operating margin, and net profit margin
• Understanding what segment disclosures mean for risk, diversification, and profitability

Common size analysis and segment reporting are often used together. Common-size statements show how much each line item contributes to the whole; segment reporting shows which business lines or regions contribute those amounts.

Common Size Analysis

Purpose and Method

Common size analysis transforms financial statement items into percentages of a specified base. For the income statement, the base is almost always total sales or revenue.

Key Term: common-size income statement
A common-size income statement shows each income and expense item as a percentage of total sales, helping analysts compare profitability and cost structure across firms and periods.

The formula is straightforward:

If Company A reports sales of $10 million and cost of goods sold (COGS) of $6 million, the gross margin is 40% of sales. In contrast, Company B has sales of $100 million and cost of goods sold of $60 million; its gross margin is also 40%. Without converting to percentages, these firms may seem difficult to compare. In common-size form, they clearly have the same production cost structure despite very different scales.

Common size analysis is also widely used for balance sheets by expressing each asset, liability, and equity item as a percentage of total assets.

Key Term: common-size balance sheet
A common-size balance sheet presents each asset, liability, and equity item as a percentage of total assets, supporting assessment of liquidity, use of debt, and capital structure.

Benefits

Common size analysis is powerful because it:

• Standardises items for cross-company analysis
• Highlights cost structure differences and trends (for example, rising administrative costs as a percentage of sales)
• Facilitates industry benchmarking against peers or averages
• Separates pricing effects (changes in revenue per unit) from cost control and efficiency effects
• Links directly to profitability ratios tested in the exam, such as gross margin and operating margin

Key Term: gross margin
Gross margin is the percentage of sales revenue remaining after deducting cost of goods sold, calculated as gross profit divided by sales. On a common-size income statement it is simply 100% minus COGS as a percent of sales.

Key Term: operating margin
Operating margin is operating income divided by sales. In common-size form it shows the proportion of sales left after both production costs and operating expenses (such as selling, general, and administrative expenses, and depreciation).

Key Term: net profit margin
Net profit margin is net income divided by sales, representing the overall profitability after all expenses, interest, and tax.

Because margins are already percentages, common-size income statements make it easy to see which part of the path from sales to net income is changing: gross margin, operating margin, or net margin.

Limitations

Despite its usefulness, common size analysis has limitations:

• It does not capture the impact of absolute size on competitive position, bargaining power, or access to financing.
• It can hide economies of scale: two firms with identical percentages but very different volumes may have different cost advantages.
• Comparability may be reduced when companies classify items differently (for example, some costs treated as COGS versus selling expenses).
• Inflation and changes in accounting policies can distort time‑series comparisons because historical figures are measured at different price levels or under different rules.
• For balance sheets, assets measured at fair value at one company and historical cost at another may not be directly comparable, even in percentage form.

Exam Tip: Common size analysis standardises structure, not measurement. In cross‑company questions, watch for notes about different inventory or depreciation methods that can affect comparability of margins.

Worked Example 1.1

Company X and Company Y each have sales of $12 million, but Company X reports cost of goods sold (COGS) of $6 million and selling expenses of $4 million, while Company Y has COGS of $8 million and selling expenses of $2 million. Prepare a common-size income statement for each and interpret the results.

Answer:
The calculations and interpretation are as follows.

• Company X:
  • COGS: $6m / $12m = 50%
  • Selling expenses: $4m / $12m = 33%
  • Other items (if any) and profit would make up the remaining 17%
• Company Y:
  • COGS: $8m / $12m = 67%
  • Selling expenses: $2m / $12m = 17%
  • Other items and profit would also sum to the remaining 16%
• Interpretation: Company X has a more efficient production process (lower COGS as a percent of sales), but much higher selling expenses. Company Y’s cost structure puts more weight on production than selling. Depending on how effective the selling expenses are in generating future sales, Company X could be investing for growth, while Company Y may be operating a leaner sales model with higher production costs.

Interpreting Common Size Statements

Common-size income statements help answer questions such as:

• Is profitability improving because of better pricing (higher sales) or cost control (lower COGS or operating expenses as a percentage of sales)?
• Are fixed costs (for example, depreciation, administrative salaries) growing faster than sales, potentially increasing operating risk?
• How does the firm’s cost structure compare with peers in the same industry?

Analysts look closely at movements in key line items as a percentage of sales:

• COGS: rising COGS % may signal higher input prices, weaker bargaining power, or lower efficiency.
• Selling, general and administrative (SG&A) expenses: increasing SG&A % might reflect marketing investment or poor cost control.
• Interest expense: a high interest expense % suggests greater use of debt and higher financial risk.
• Income tax expense: differences in effective tax rates affect net margins but may reflect jurisdictional mix rather than operating performance.

Worked Example 1.2

Over three years, Company Z’s common-size income statement shows that administrative costs have risen from 10% to 14% of sales, while sales have grown only modestly. What action might an analyst take?

Answer:
The analyst should investigate the nature of the additional administrative costs. Key questions include: Are the extra costs linked to future growth (for example, investment in systems or new management teams), or do they indicate deteriorating cost control? If there is no clear link to future benefits, the rising administrative cost percentage may signal declining efficiency and pressure on operating margin.

Common Size Analysis of the Balance Sheet

Although the Level 1 syllabus emphasises common-size income statements, the same technique applies to the balance sheet by taking total assets as the base.

Common-size balance sheets are useful for:

• Assessing liquidity: proportion of current assets and cash relative to total assets
• Assessing solvency: proportion of liabilities relative to total assets and the mix of short‑term versus long‑term financing
• Comparing capital structure strategies across firms

Key Term: liquidity
Liquidity is a company’s ability to meet its short‑term financial obligations using cash and other assets that can be quickly converted to cash.

Key Term: solvency
Solvency is a company’s ability to meet its long‑term obligations and continue as a going concern, often assessed through the proportion of debt in its capital structure.

Consider three firms with the same total assets but very different compositions. One holds mostly cash and marketable securities with almost no liabilities, another holds large inventories and payables, and a third is financed almost entirely by long‑term debt. Common-size percentages highlight:

• Which company is most liquid (highest percentage of cash and near‑cash items)
• Which company uses the most debt financing (highest percentage of liabilities, especially long‑term debt)
• Which company has invested most heavily in property, plant, and equipment (PP&E), suggesting a capital-intensive model

Worked Example 1.3

Three companies all report total assets of $3.25 million. Company A has 77% of its assets in current assets and virtually no liabilities. Company B has 68% in current assets but current liabilities equal to 77% of total assets. Company C (a larger peer) reports 52% in current assets and total liabilities equal to 98.5% of assets. Compare their liquidity and solvency using common-size percentages.

Answer:
Using total assets as the base:

• Company A: High current asset percentage and almost no liabilities indicate strong liquidity and very strong solvency. It can easily meet short‑term obligations and uses very little debt financing.
• Company B: Although it appears liquid in terms of current assets, its current liabilities (77% of assets) far exceed its cash holdings. Its liquidity is weaker than Company A’s, and it may rely on receivables collection or inventory sales to pay short‑term obligations.
• Company C: It has moderate liquidity (around half of assets are current) but very high reliance on debt (liabilities finance almost all assets). Liquidity looks reasonable in the short term, but solvency is a concern because small declines in cash flow could make it difficult to service debt.
  This example shows how common-size balance sheets highlight liquidity and solvency risks that would be less clear from raw numbers alone.

Using Common Size Analysis for Cost Inflation

Common-size analysis is especially helpful in understanding the impact of changes in input costs on margins.

Suppose two consumer staples companies, Sweet B and Choco A, have the following cost structures (as a percentage of net sales):

• Sweet B: COGS 50%, SG&A 31%, depreciation 3%, EBIT 16%
• Choco A: COGS 36%, SG&A 47%, depreciation 4%, EBIT 13%

Within COGS, both have raw materials at 22% of sales, but Sweet B has higher “other COGS” (manufacturing overhead) than Choco A.

Worked Example 1.4

Assume that all costs except depreciation rise by 10%, but sales prices cannot be increased. Using common-size analysis, which company will experience a larger proportional decline in gross margin?

Answer:
The impact on gross margin depends on the starting COGS percentage.

• Sweet B: Initial COGS = 50% of sales. A 10% increase in all COGS components raises COGS to 1.10 × 50% = 55%, so gross margin falls from 50% to 45%. This is a 10% proportional decline (from 50% to 45%).
• Choco A: Initial COGS = 36% of sales. A 10% increase in COGS raises it to 1.10 × 36% ≈ 40%, so gross margin falls from 64% to 60%. This is roughly a 6% proportional decline (from 64% to 60%).
  Interpretation: The company with the higher COGS percentage, Sweet B, suffers a larger proportional reduction in gross margin when input prices rise and selling prices cannot be adjusted. Common-size analysis makes this impact immediately visible.

This type of question is common at Level 1: you are not asked to build full financial forecasts, but to interpret how changes in costs or prices would affect common-size margins.

Segment Reporting

Why Segment Analysis Matters

For companies with diverse operations, aggregate financial statements may conceal risks or mask the performance of individual business areas or geographies. A single consolidated operating margin may combine:

• Mature, highly profitable segments
• Fast-growing but currently low-margin segments
• Loss‑making segments that threaten overall sustainability

Segment reporting is required for material operating and geographic segments so that users can see:

• Where revenues and profits are actually generated
• Which segments are driving growth
• Which parts of the business carry higher risk (for example, more cyclical, more heavily indebted, or in riskier countries)

Key Term: business segment
A business segment is a component of a company that engages in business activities, earns revenues and incurs expenses, and whose financial results are regularly reviewed by the company’s chief operating decision maker.

Key Term: geographic segment
A geographic segment is a component of a company that earns revenues and incurs expenses within a particular country or region and is subject to specific economic and political risks.

Modern standards adopt a “management approach”: operating segments are based on the internal reporting used by senior management.

Key Term: management approach (segment reporting)
Under the management approach, operating segments are identified based on the internal reports that are regularly reviewed by the chief operating decision maker (for example, the CEO), rather than on predefined product or geographic lines.

What Is Disclosed

Large companies must disclose segment performance, including:

• Revenue to external customers
• Inter-segment revenue (sales between segments)
• A measure of segment profit or loss (often operating profit)
• Segment assets and, under IFRS, segment liabilities if used internally
• The basis of measurement (for example, whether segment profit includes allocated head office costs or not)

Key Term: reportable segment
A reportable segment is an operating segment that meets specified quantitative thresholds and therefore must be disclosed separately in the financial statements.

Under both IFRS and US GAAP, an operating segment becomes a reportable segment if it meets any one of the following 10% tests:

• 10% of combined segment revenue (including both external and inter‑segment revenue)
• 10% of the greater (in absolute amount) of:
  • combined profit of all profitable segments, or
  • combined loss of all loss‑making segments
• 10% of combined segment assets

In addition, the total external revenue of all reportable segments must be at least 75% of the entity’s total external revenue. If not, additional segments must be designated as reportable until this 75% threshold is met.

Other required disclosures include:

• Reconciliations of total segment revenue, profit or loss, and assets to the corresponding totals in the consolidated financial statements
• Entity‑wide disclosures of revenue by product or service, revenue by geographic area, and information about major customers (any single external customer that provides 10% or more of total revenue)

Exam Tip: A common multiple-choice test point is the 10% thresholds and the 75% combined revenue rule. Remember: meeting any one of the three 10% criteria makes a segment reportable, and reportable segments must together cover at least 75% of external revenue.

Worked Example 1.5

A company has four operating segments with the following external revenues: W: 45%, X: 25%, Y: 18%, Z: 12% of total external revenue. All segments have similar asset levels and profits, and each meets at least one 10% test. Which segments must be reported separately, and does the company meet the 75% revenue test?

Answer:
Because each segment meets at least one 10% threshold, all four are reportable segments. Their combined external revenues total 45% + 25% + 18% + 12% = 100% of the company’s external revenue, which exceeds the 75% requirement. The company therefore satisfies both the 10% tests and the 75% coverage test.

Worked Example 1.6

A global conglomerate reports overall operating profit margin of 8%. Its segment disclosures show Segment A (consumer products) with a 15% margin and Segment B (industrial products) at 4%. What does this indicate?

Answer:
Segment A is significantly more profitable than Segment B. Because Segment A’s margin (15%) is well above the consolidated margin (8%), Segment A is pulling the overall margin up. Segment B’s lower margin (4%) drags the consolidated margin down. An analyst might:

• Value the segments separately, applying different multiples to Segment A and Segment B.
• Assess whether management should invest more in Segment A (higher margin) and consider restructuring or improving efficiency in Segment B.
• Consider the risk profile: consumer products may be less cyclical and more stable, while industrial products may be more sensitive to economic downturns.

Interpreting Segment Disclosures

Segment disclosures can be used to:

• Identify high‑margin versus low‑margin segments and assess how they contribute to consolidated earnings.
• Evaluate diversification: a company with multiple profitable segments in different regions and industries may be less risky.
• Understand geographic risk exposure and dependence on particular countries or regions.
• Detect segments that are consistently loss‑making and may need restructuring or disposal.
• Assess sustainability of performance: a consolidated profit trend driven by one narrow, cyclical segment may be less sustainable than broadly distributed profits.

Analysts often calculate segment‑level ratios, such as:

• Segment operating margin = segment operating income ÷ segment revenue
• Segment asset turnover = segment revenue ÷ segment assets
• Segment return on assets (ROA) = segment operating income ÷ segment assets

These are interpreted in the same way as whole‑company ratios but reveal differences between segments.

Exam Warning

Exam Warning: Failing to examine segment data can result in missed risk exposures or undervalued growth drivers. Always review segment notes and reconcile them with the consolidated financial statements for a complete picture. Be aware that segment profit measures may exclude some corporate costs, so segment margins are not always directly comparable with consolidated margins or across companies.

Common Size Analysis and Segments Combined

Analysts often prepare common-size statements by segment to compare divisions of a single company or competitors’ business segments. For example, segment common-size income statements can reveal that:

• One segment has higher COGS as a percentage of sales than another, indicating higher input costs or weaker pricing power.
• Another segment has much higher SG&A %, suggesting heavy marketing spend or inefficiency.
• A particular geographic segment contributes a small percentage of revenue but a large percentage of profit, or vice versa.

This helps pinpoint:

• Sources of profitability and areas for operational improvement
• Segments that are more vulnerable to input cost inflation or price competition
• Segments where management might shift resources to maximise shareholder value

Common-size segment data can also be combined with risk information. For instance, if a high‑margin segment operates in a politically unstable region, the analyst must consider both its positive contribution to profits and the elevated geopolitical or regulatory risk.

Revision Tip

Revision Tip: Under time pressure in the exam, focus first on common-size gross margin, operating margin, and segment disclosures. These quickly reveal the true drivers of performance and risk and are frequently central to Level 1 questions.

Summary

Common size income statement analysis standardises financial data by converting each line item into a percentage of sales, making it easier to perform meaningful cross‑company comparisons and to analyse trends over time. It clarifies whether changes in profitability stem from pricing, volume, or cost control and links directly to margins and ratios tested in the exam. Common-size balance sheets extend the same logic to assets, liabilities, and equity, providing information on liquidity and solvency.

Segment reporting complements this by breaking down performance for diversified firms into business and geographic components. Required disclosures under IFRS and US GAAP—based on the management approach—include segment revenue, profit or loss, and assets, with quantitative 10% thresholds and a 75% coverage rule determining which segments must be reported separately. Analysts use segment data to assess diversification, isolate high‑ and low‑risk areas, and evaluate whether consolidated performance is sustainable.

Together, common size analysis and segment reporting provide a structured way to interpret financial statements beyond raw totals. Used thoughtfully, they help identify the real drivers of profitability and risk. However, they must be applied with awareness of limitations, including differences in accounting policies, the effects of inflation, management discretion in defining segments, and the fact that percentages alone do not capture absolute scale or competitive position.

Key Point Checklist

This article has covered the following key knowledge points:

• Common size analysis converts absolute financial data into percentages relative to a base (sales for income statements, total assets for balance sheets).
• Common-size income statements highlight cost structure and profitability through gross, operating, and net profit margins.
• Common-size balance sheets help assess liquidity and solvency by showing the composition of assets and financing.
• Segment reporting, based on the management approach, reveals performance detail at business and geographic levels.
• Reportable segments are identified using 10% thresholds for revenue, profit or loss, or assets, and reportable segments must account for at least 75% of external revenue.
• Analysts use segment margins and common-size figures to compare segments and companies’ profitability, cost structure, and risk exposure.
• Reviewing segment disclosures is essential for identifying firm‑specific risk, diversification, and key performance drivers.
• Limitations include lack of information about absolute size, economies of scale, differences in accounting policies, and management discretion in defining and measuring segments.

Key Terms and Concepts

• common size analysis
• segment reporting
• common-size income statement
• common-size balance sheet
• gross margin
• operating margin
• net profit margin
• liquidity
• solvency
• business segment
• geographic segment
• management approach (segment reporting)
• reportable segment